All Change as Middle East Gets Out With the Old, In With the New
Solomon Teague, Hedge Funds Review
The Middle East is still better known for its wealthy investors than for its resident hedge fund community, but there are hedge funds operating in the region, hoping to capitalise on proximity to some of the world’s wealthiest investors.
Kevin Birkett, asset and fund management director at the Dubai Financial Services Centre (DIFC) notes there are already two small funds present in the DIFC. Local markets are prohibitive for them: it is not possible to short and although there are some synthetic products available they are not liquid enough to be really appealing to hedge funds.
And Al-Bader believes the product offered by the DIFC allowing for the creation of local hedge funds is very favourable from a regulatory perspective.
Al-Bader agrees there are relatively few hedge funds residing in the Middle East still, although he says large multi-strategy funds with emerging markets operations often have teams in Dubai. He believes the local hedge fund industry is already on an upward trajectory that will continue to grow in line with the rest of the industry, particularly as local players’ wealth and experience in the industry expands.
Within the Middle East society is split between the older generation, often the family patriarchs, who tend to be less enthusiastic about alternatives, and the younger generation who are more sophisticated, Birkett says.
Dubai doesn’t always reflect the rest of the Middle East, says Birkett. Most Dubai investors sit at the liberal end of the Islamic scale, unlike investors from places such as Saudi Arabia, and are therefore more open to sophisticated hedge fund products that are not Shariah compliant.
But even in more traditional places, such as Kuwait, there is an acceptance of the merits of hedge funds. Fahad Al-Bader is head of hedge funds at the Kuwait Fund for Urban Economic Development, an aid agency providing financial assistance to developing nations with nearly 3.88 billion Kuwait dinars (US$13.93 billion) in commitments. It has 6% of its portfolio allocated to hedge funds and it is set to rise to 8%, according to Al-Bader.
The majority of the funds’ hedge fund allocations are made to hedge funds of a broad range of strategies in the US, Europe and Asia.
“The landscape has changed in recent years,” agrees Francis Akpata, investor relations manager at Acropolis Capital Management, a fund of hedge funds affiliated to a family office active in the Middle East. Local investors are more sophisticated than ever before with regards to hedge funds, he says.
“It is no longer an easy source of capital as a fund’s brand name and size, measured by assets under management, will no longer impress clients who now have a more sophisticated approach to choosing products.”
The mentality of the Middle Eastern investor is changing as the older generation are replaced by their younger and more sophisticated children, and in response to what Birkett describes as “one of the biggest booms in the history of the planet,” which the region has been experiencing, in construction and elsewhere.
Akpata notes, with oil prices breaching the US$90 level per barrel, oil is estimated to contribute about US$300 billion to the Middle Eastern economy. “This all follows some years when the financial sector – and equity markets in particular – within the region have performed quite well, generating good returns for institutional and private investors,” he says. “These two factors have initiated a culture of capital-preservation amongst the institutional investors, particularly those backed by governments and who receive some state capital.
They are aware that the rising oil prices may not continue and that the shelf life of oil reserves is limited. The capital preservation is also combined with a desire to invest to achieve very good risk-adjusted returns from their investments.” This has fuelled that boom.
“Ever since the period of the oil boom in the 80s, the Middle East has always attracted international asset managers due to the wealth controlled by institutional investors, high net worth individuals and family offices,” says Akpata.
“But the region has changed in the last five years. There is no longer room for the international asset managers and private bankers who would fly in for an annual visit, and expect to scoop up large investments with whatever products they happened to offer.” Middle Eastern investors are now more discerning about what they buy, and place more emphasis on relationships, meaning it is increasingly important to have a permanent presence in the region.
Akpata cites statistics from Casey, Quirk & Associates, a management consultancy for investment management firms, which indicate that last year Middle Eastern institutions were responsible for 8% of the investments in hedge funds.
“International asset managers also have to take the local situation within each country into consideration,” he says.
“Privatisation and deregulation has precipitated an increase in investor confidence within some states. Greater liquidity and lower interest rates have facilitated more cross-border investment. Development in the UAE has encouraged several leading international institutions to set up a presence there, and encouraged similar activity in places like Qatar and Bahrain.”
He points out there are also domestic funds where 10% of the oil surplus is invested to save for a less prosperous future. This, hopefully, will protect alternative investments from some of the redemptions that might have been expected in the event of an oil price shock.
The construction boom in particular has reinforced the Arab love of investing in physical things, says Birkett, such as buildings. Coupled with the volatility many investors have experienced in the local markets, which rose 100% in three years and then lost 80% in one, has helped dissuade many from investing in any financial markets at all and concentrate on more tangible assets whose value they trust will survive outside forces.
This in part explains the popularity of private equity in the region, Birkett explains: “They can see it and they understand it.” In some ways, he adds, they see the industries progress over the last 15 years as analogous to their own experience, in the steady increase in sophistication and entrepreneurialism.
REITS are also very popular, along with any exposure to property, Birkett says. Investors are keen to access not just the boom they see in their own countries but elsewhere in Asia, particularly places like India.
The relatively modest advances made by hedge funds amongst Middle Eastern investors has less to do with religion and more to do with an aversion to investing in things they do not fully understand, Birkett says.
Notwithstanding this, some esoteric hedge funds are proving popular in Dubai, says Birkett. A significant proportion of the wealth in the region is managed not by individuals themselves but by wealth managers, who are gradually becoming more au fait with such vehicles.
Al-Bader says some of the biggest hedge fund investors in the world are in the Middle East, foremost among which are some of the regional government bodies, which have significant sums of oil wealth to invest. But institutions and wealth families are also open to investing in hedge funds, he says.
Hedge funds are a very important part of their strategies, he says: a blend of private equity and hedge funds makes for the healthiest portfolios, he notes, with private equity generating strong returns but hedge funds seen as useful for their favourable liquidity terms and for diversification.
The growing popularity of hedge funds has seen major advances for funds of hedge funds too, Akpata notes. He cites Bank of New York research which predicts Middle Eastern institutional investment in hedge funds will reach US$140 billion by 2010. Local investors have also increased their analysis and scrutiny of these hedge funds, he notes.
“If they are to invest in an international fund of hedge funds they intend first to ascertain what constitute the returns in the portfolio and if the alpha the manager generates is any different from that which they could achieve within the MENA or GCC regions,” Akpata says. “They also require better risk management and regular reports from external asset managers.”
Akpata says Middle Eastern due diligence is now as thorough as anything conducted elsewhere. “The portfolio manager’s asset allocation, risk management and ability to generate consistent returns under different market conditions are clearly scrutinised to ensure that he runs a unique value-strategy,” he says.
“The institutional investors from the MENA now have sophisticated investment strategies and tend to make allocations to funds of hedge funds with portfolios containing funds to which they would not easily have access. They need to see that the fund of fund manager is able to reduce volatility and put together a portfolio of managers producing high returns.”
It is crucial investors see evidence of active management adding value, he says.
“They can achieve diversification using international hedge fund indices. A decade ago they were comfortable with making allocations just to the few larger funds of hedge funds but more recently they have become more open-minded and have broadened their selection criteria.”
Growing interest amongst investors for alternative assets has seen intensification in competition amongst foreign institutions wishing to get a piece of the action by setting up a presence within the Middle East, observes Akpata. Domestic asset managers are entering the fray too, developing their own products and exploiting their knowledge of the local markets. “The competition amongst professional hedge fund managers, be they domestic or international, has brought about more transparency and choice for clients,” says Akpata.
The question of religion is a very personal one, explains Birkett, and it is difficult to make generalisations about attitudes to instruments that do not comply with Shariah principles. As with anywhere in the world there are those who adhere to religious principles strictly and those who do not. Birkett says some of the principles are followed almost universally, for example rejection of pork and alcohol, but exposure to debt is less offensive to many people.
Emirates Airlines, for example, a flagship regional company owned by the Dubai government, uses both traditional and sophisticated financial techniques used by its Western competitors to remain profitable and competitive, observes Birkett.
“The treasury departments of state-owned firms like shipping and mining companies are also using products like multi-strategy hedge funds to invest their extra income and achieve diversification,” agrees Akpata.
“They select alternative products that enable them to diversify out of their domestic market and take advantage of opportunities in other markets around the world. With this goal in mind they normally choose asset managers who can cherry-pick best of the breed, or specialists within these sectors and monitor them on a regular basis.”
There is therefore certainly a demand for mainstream hedge fund products in the Middle East. The development of Islamic alternative investment structures has been a major theme of the last year and it is hoped a greater number of Shariah-compliant options offering hedge-type exposures will help the industry to take off in the Middle East.
Birkett believes this is a reasonable hope but predicts the Shariah-compliant offerings will never usurp traditional hedge funds in the region completely. “Principles have costs,” he warns. For those with the main priority of maximising returns, real hedge funds will always have the advantage, he says.
Ultimately, the Middle East is made up of a number of different countries with divergent cultures and regulatory environments, and even within the countries themselves there are differences in sophistication and investment goals.
“The different countries approach the allocation to these funds differently in terms of their structures and the policies they adopt,” says Akpata. “They have one thing in common, however, which is to preserve capital and invest for the future.”